Question

You have been asked to forecast the additional funds needed (AFN) for Houston, Hargrove, & Worthington (HHW), which is planning its operation for the coming year. The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 40%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.

Last year's sales = S0	$300.0	Last year's accounts payable	$50.0
Sales growth rate = g	40%	Last year's notes payable	$15.0
Last year's total assets = A0*	$500	Last year's accruals	$20.0
Last year's profit margin = PM	20.0%	Initial payout ratio	10.0%

Select the correct answer.

a. $21.3

b. $26.5

c. $22.6

d. $23.9

e. $25.2

Answer 1

Formula for Additional Funds Needed(AFN):-

AFN = (Total Assets/Last year's Sales)*Change in sales - (Spontaneous Liabilities/Last year's Sales)*Change in sales - [Forecasted Sales*Profit Margin*(1-Payout Ratio]

where, Change in Sales = Last year's sales*Sales growth rate

=$300 millions*40%

=$120 million

Spontaneous Liabilities = Accounts Payable + Accruals

=$50 million + $20 million

=$70 million

Note - (Notes Payable are not part of Spontaneous Liab)

Forecasted Sales = Last year's sales*(1+Sales growth rate)

=$300 million*(1+0.40)

=$420 million

- Calculating AFN when Payout Ratio is 10%: (Amounts in millions)

= [($500/$300)*$120] - [($70/$300)*$120] - [$420*20%*(1-0.10)]

= $200 - $28 - $75.6

=$96.4

- Calculating AFN when Payout Ratio increased to higher level which is 40%: (Amounts in millions)

= [($500/$300)*$120] - [($70/$300)*$120] - [$420*20%*(1-0.40)]

= $200 - $28 - $50.4

=$121.6

So, the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level

= $121.6 - $96.4

=$25.2

Hence, Option E

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